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Tuesday, March 29, 2016

For
centuries, the bedrock assumption of finance was that borrowers paid interest
and lenders and investors received interest, and that nominal interest rates
would always be positive. That assumption has been turned upside down in recent
years as lenders are now paying interest to borrowers; this prevails mostly in
the commercial banking industry on banks’ deposits, called reserves, at the
central bank. These reserves can either be required to back customer deposits
at the bank or excess, those not needed to back customer deposits. Central
banks are now charging commercial banks in 23 countries for their reserves on
deposit or on their excess reserves.

Ever since
the Great Recession (2008-2009), central banks have had to do the heavy lifting
getting economic growth back on track and reducing deflationary pressures.
First came the near-zero interest rate policies (NZIRPs), then quantitative
easing (QE) and now the negative interest rate policies (NIRPs). The NZIRPs
were implemented to boost aggregate demand by consumers and corporate
investment by lowering borrowing costs. Another intent was to create a wealth
effect by increasing bond, stock and housing prices, making consumers less
risk-averse and more willing to spend or invest. QE programs involved massive
amounts of bond purchases by central banks with the intent of lowering
long-term interest rates on mortgages, auto loans and corporate bonds. The
NIRPs work on the supply side by making loans more readily available to
borrowers. Central banks impose an interest rate on bank reserves to motivate banks
to lend excess reserves to borrowers to help invigorate lethargic economic
growth. And there are unprecedented amounts of excess reserves on deposit at
central banks.

The central
bank of Sweden was the first to have an NIRP in 2009 but dropped it and raised
interest rates as the economy improved. The ECB started its NIRP in June 2014
at -0.3%, joining Sweden (-0.5%), Denmark (-0.65%) and Switzerland (-0.75%). In
January Japan joined the 22 European countries, 19 in the Eurozone, by
implementing an NIRP with a -0.1% charge on some bank reserves as well as
maintaining a massive QE program. In March, the ECB made a further cut in its
negative rate to -0.4% and increased its QE program to €80b monthly, including
the purchase of investment-grade corporate bonds denominated in euros. They
also cut the short-term borrowing rate by banks to zero. Interestingly, the ECB
imposed a negative rate on itself by offering to pay banks 0.4% to borrow money
on a longer-term basis up to 4 years, as long as the banks lend the borrowed
money.

These NIRPs
have carried over to the bond markets as $7t of bonds, mostly government, have
negative yields. This represents 25% of all government bonds outstanding in
developed countries. In Japan and Switzerland, government bond yields are
negative out to 10 years maturity, 8 years in Germany and the Netherlands, 7
years in Belgium and France, 5 years in Sweden and Denmark, 4 years in Italy
and 2 years in Spain. A year ago there was less than $1t of government bonds
with negative yields. There are also billions of dollars of corporate bonds
with negative yields mostly in Europe and Japan. Some corporate bonds have been
issued with a negative yield, Nestlé in Switzerland and more recently a bank in
Germany. Today two-thirds of the $26t of government and corporate bonds in the
Bank of America Merrill Lynch bond index have yields that are less than 1% or
negative.

What are the
potential problems with NIRPs? There are a multitude. Low and negative interest
rates are challenging for banks that borrow (take deposits) short term and lend
or invest long term. Thus far banks have been reluctant to impose negative
rates on deposits but have had to lower rates on loans, sometimes negative, to
stay competitive. Their net interest margin is being squeezed. Life insurance
companies are also impacted as they have guaranteed rates on annuities and
other insurance products. Money market funds have struggled with NZIRPs and
NIRPs just exacerbated their margins or lack thereof: eleven of the largest
money market funds in Japan have turned away new deposits and may return
existing funds to depositors. NIRPs present problems to defined benefit pension
plans that have assumed returns on investments well in excess of bond yields.
More NIRPs may have dire consequences for many financial institutions. And
NIRPs are a repression on savers who are receiving near-zero interest rates and
perhaps negative in the future.

In addition
to financial institutions and savers, NIRPs potentially increase risks to
financial system stability by creating bubbles in financial assets like stocks
and bonds and real assets like housing. It may also create problems for
investors chasing yields in riskier assets and longer maturity assets. Many
believe the primary objective of NIRPs is to weaken currencies and make a
country’s exports more competitive. This is a zero-sum game if all countries
try to devalue and risks the potential of currency wars and trade
protectionism. Finally, NIRPs may signal that prior monetary policies such as NZIRPs
and QE have failed and people will lose confidence in central banks and then
they have a credibility problem.

One unintentional
consequence of NIRPs has been cash hoarding and a surge in safe sales in Europe
and especially Japan. The cash hoarders are ordinary citizens responding
rationally to NIRPs which work only if savers spend or invest their money. Money
is unproductive if stuffed under a mattress or in safes and safe deposit boxes.
Cash hoarders prefer large denominations as do those carrying out illicit
activities such as drug trafficking, money laundering, tax evasion, corruption
and terrorist activities. The high denomination notes like the $100 bill, the €500
note, the SFR1000 note and the ¥10,000 note make up the largest
portion of the respective paper currencies.

Demand for these has accelerated in
Europe and Japan; circulation of the SFR1000 notes ($1010) grew 17% in 2015
after Switzerland imposed a NIRP in January 2015.

Cash hoarding is an impediment to NIRPs and because of that
some economists want to retire high-denomination notes and others to eliminate
all paper currency and go digital. Theoretically negative interest rates can go
lower but are constrained by cash hoarding, shadow banks and other factors.

NZIRPs, QE and NIRPs all had the same objective of
stimulating stagnant economies. The question is have they worked? Japan has had
an NZIRP and QE for some time but their NIRP is just two months old. The
initial reaction to it was not as expected. The yen did not weaken, but
strengthened relative to the dollar by 8%, savings increased and borrowing
declined as citizens began to hoard cash. An NIRP has not helped Europe which
is still experiencing anemic growth and deflationary pressures. There have not
been a lot of positives so far with the NIRPs, except perhaps for lower
borrowing costs, especially for governments, but that also could have unintentional
consequences. The lack of robust economic growth in the countries that have
implemented these policies may be due to other economic headwinds, and these
economies may have been in worse shape if the policies had not been adopted.

Christine Lagarde, managing director of the International Monetary Fund, states
“if we had not had those negative rates, we would be in a much worse place
today with lower growth and lower inflation.” Former Fed Chairman Ben Bernanke
stated in his blog that negative interest rates “appear to have both modest
benefits and manageable costs” and that “market anxiety over below-zero
borrowing costs seems to me to be overdone.”

Even though
the Fed raised short-term rates in December, some, including Congress, are
questioning whether the U.S. could experience negative interest rates in the
future. Janet Yellen, Fed chairperson, stated in congressional testimony in
February that negative rates were discussed in 2010 but not implemented at that
time. She also stated that she was not aware of anything that would prevent the
Fed from implementing a NIRP but it would need further investigation of legal hurdles.
The Fed already includes a negative interest scenario in bank stress tests and
short-term U.S. Treasury bills have occasionally had negative yields.

If these
monetary policies lose their efficacy or potency, what might be the last salvo
of monetary policy? One possibility is what the late Milton Friedman referred
to as a “helicopter dumping policy” (HDP). This would entail the central banks
directly financing government spending or tax cuts, or directly sending checks
to tax payers. This would be a more dramatic monetary policy than the three
prior ones and would certainly be the “big bazooka” in stimulative monetary
policy. It is hard to imagine HDPs ever
being implemented, but a decade ago the same could have been said about NZIRPs,
QE or NIRPs.